SEC Division of Investment Management staff letter: Adam W. Glass

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON. D.C. 20549 ACT Icf7 - /9LfO

DIVISION OF

INVESTMENT MANAGEMENT SETION
RULE ;;0. - 7
PUBLIC
A V AILABIL 7 -;) 0 - c¡ 1/
July 20, 1994

Ada W. Glass, Esq.
Orrck, Herrgton & Sutclife
599 Lexigton Avenue

New York, NY 10022

Dear Mr. Glass:
Your letter dated July 19, 1994 (a copy of which is attched) requests that the Division of Investment Management agree that the short-term municipal ratings assigned to Series C Revenue Anticipation Warrts issued by the State of Calorna ("RAWs") wil be treated as long-term debt ratings under pargraph (c)(3)(ii) of rule 2a-7 if the RAWs are converted into Varable Rate Instruments (as this term is defined in pargraph (a)(21) of rule 2a-7) that are eligible for purchase by money market funds ("Synthetic RAWs"). You represent that, consistent with this defintion, upon adjustment of the interest rate of a Synthetic RAW, the market value of the Synthetic RAW can reasonably be expected to approxiate its par value. You state that the RAWs wil mature in 22 months, and the entire pricipal and interest amount wil be payable on Apri 25, 1996. Prcipal and interest on the RAWs is guarantee by the unconditional obligation of a consortium of fourteen bans ("Bans") to purchase the RAWs on the maturity date under the terms described in your letter.1 The RAWs wil receive "short-term" ratings from three nationaly recognied statistical rating organations ("NRROs") as follows: Moody's Investors Service - MIG-1; Stadad & Poor's Coiporation -- SP-1; and Fitch Investors Service -- F-1 +. Thus, the RAWs wil be rated by the Requisite NRROs (as such term is defined in pargrph (a)(13) of rule 2a-7) withi the highest generic ratig category for short-term municipal

obligations (withi which there may be sub-categories or gradations indicatig relative stading). You represent that the short-term obligations of each of the Ban are also rated in the highest generic short-term categories by a NRRO. Not al the Bans wil have long￾term debt obligations rated in one of the two highest generic long-term rating categories by a

NRRO. You also advised that the short-term debt of the issuers of the Demand Features (as that term is defined in pargraph (a)(4) of the rule) wil have the highest short-term debt ratings from the Requisite NRROs. The obligations of the Bans are severa; that is, if one Ban defaults in its obligation to repurchase its portion of the RAWs, the other Bans are not required to assume the obligation of the defaultig Ban and purchase more than their alotted shares.

• 2
  The Synthetic RAWs wil be subject to a conditional Demand Feature. The Demand Feature wil permit the holder of a Synthetic RAW to "put" the instrment back to the put provider on each interest rate reset date. In your letter and subsequent telephone cals, you advised that the Demand Feature "wil be subject to customar conditions on its exercise," including the downgrade of the ratings of the RAWS or any Ban to below investment grde. Pargraph (c)(3)(ii) of rule 2a-7 provides that an instrment subject to a conditional Demand Feature is an Eligible Security (as that term is defined in pargrph (a)(5) of rule 2a-7) if: (1) the Demand Feature is rated by the Requisite NRROs in one of the two highest rating categories for short-term debt obligations; and (2) the underlying security is rated in one of the two highest rating categories for long-term debt obligations. If such instruments are not rated by a NRRO, they must be determined to be of comparble qualty. Based on your ora and written representations and without necessary agreeing with your legal analysis, the Division wil not object if money market funds purchasing the Synthetic RAWs treat the short-term ratings assigned to the RAWs as ratings assigned to long-term debt obligations for puiposes of pargraph (c)(3)(ii) of rule 2a-7. We note that, as with any other instrument, a money market fund may invest in Synthetic RAWs only if its board of directors (or the board' s delegate) determines that the Synthetic RAWs present minal credit risks (which determination must be based on factors pertg to credit qualty other than the rating assigned by an NRSRO). Pargraph (c)(3) of rule 2a-7. Ths letter does not address whether Synthetic RAWs present minal credt risks. Because the Bans' obligations are severa, a fund must evaluate, among other thigs, the credit qualty of each Ban. Sincerely, 4U8A￾Robert E. Plae Assistat Director

I)RRICK, HERRINGTON
&: SUTCLIFFE
July 19, 1994 DiTedDil

VIA TELECOPIER

Assistant Director

Division of Investment Management

Washington, D. C. 20549

Re: Status of Certain Synthetic Securities
Backed by California RAWs as Eligible

Investments for Money Market Funds

Dear Mr. Plaze:
As we discussed earlier today, this letter sets forth

our view as to why the synthetic securities described below are

eligible for purchase by money market funds under Rule 2a-7.

Background
Tomorrow the State of California will price $4 billion

of revenue anticipation warrants ("RAWs") maturing in 22 months.

The entire amount of principal and interest due on the RAWs will

be payable in a single payment on April 25, 1996, the maturity

date of the RAWs (i. e., there will be no periodic payments of

interest prior to maturity). The RAWs are issuable in separate

series. Payment of principal and interest on the Series CRAWs

is effectively guaranteed by the unconditional obligation of a

consortium of 14 banks (the "Banks") to purchase the RAWs on the

maturity date, pursuant to a bond purchase agreement, at a

purchase price equal to the principal and accrued interest

thereon, if payment of the principal and interest of the RAWs is

not made in full by the State of California on the maturity date.

The obligations of the Banks under the bond purchase agreement

are several; that is, if one Bank defaults in its obligation to

repurchase its portion of the Series C RAWs, the other Banks are

not required to assume the obligation of the defaulting Bank and

purchase more than their allotted shares. The Series C RAWs will

be rated F-1+ by Fitch Investors Service ("Fitch"), MIG-l by

Moody's Investors Service ("Moody's") and SP-l by Standard &

Poor's Corporation ("S&P"), and will not be rated by any other

NRSRO. (Fitch, Moody's and S&P are referred to collectively

hereinafter as the Rating Agencies.) Each such rating represents

the highest generic rating category used by the assigning NRSRO

in rating short-term municipal obligations. The short-term debt

obligations of each Bank are rated "Al/Pl" or the equivalent.

59 Legtn Avenue · New York, New York 10022

Telephone 212 326 88 . Facsime 212 326 890

Sa Frci 415 392 1122 · Los Aneles 213 629 20io . Saciento 916 447 9200 · w.hingtn. DC. 202 628 4700

(tRRICK, HERRINGTON
&: SUTCLIFFE

July 19, 1994

However, we understand that not all the Banks have long-term debt

obligations rated "M" or higher by an NRSRO.

Proposed Synthetic Securities

We represent CS First Boston and other investment

bankers as potential purchasers of the Series CRAWs. Our clients intend to repackage the Series C RAWs into synthetic

floating rate securities for sale to money market funds. While

the details of the synthetic securities to be issued may vary

from sponsor to sponsor, you may assume for purposes of this

letter that each such synthetic security (each, a "Synthetic

Security") will be a Variable Rate Instrument as defined in

paragraph (a) (21) of Rule 2a-7 (the "Rule"); that is, its

interest rate will adjust on set dates and upon such adjustment

its market value can reasonably be expected to approximate its

par value. Furthermore, such Synthetic Security will be subject

to a Demand Feature which permits the holder to "put" the

Synthetic Security to a bank or other put provider at a purchase

price equal to par plus accrued interest on each interest rate

reset date. The Demand Feature will be subj ect to customary

conditions on its exercise and will therefore not qualify as an

"Unconditional Demand Feature" as defined in paragraph (a) (19) of the Rule.

Analysis
Based on earlier conversations with you we understand

that for the Synthetic Securities to be "Eligible Securities"

under paragraph (a) (5) of the Rule, in pertinent part, (1) the

Demand Feature must be rated by the Requisite NRSROs in one of

the two highest rating categories for Short-term debt

obligations, and (2) the underlying or "core" security (in this

case the Series C RAWs) must be rated in one of the two highest

rating categories for Long-term debt obligations. (We understand

the staff's interpretation of this provision under the existing

Rule to be substantially the same as what is set forth somewhat more explicitly in paragraph (c) (3) (ii) of proposed Rule 2a-7.) A question has arisen whether the ratings of F-1+,

MIG-1 and SP-1 by the Rating Agencies of the Series C RAWs are

sufficient to constitute ratings in one of the two highest rating

categories for Long-term debt obligations for purposes of the

Eligible Security determination under the Rule. Because these

NYl-59189.2

(tRRICK, HERRINGTON
&: SUTCLIFFE

July 19, 1994

ratings are generally recognized as short-term rather than long-

term ratings, concern has been expressed that these ratings may

not satisfy the Rule's requirement that the "core security" have

a Long- term rating in one of the two highest categories.

While we are not familiar with the reasons for the

Rating Agencies' determination to rate the California RAWs with a

rating customarily given to short-term obligations (i.e., those

maturing in a year or less), we believe that these ratings are

sufficient to meet the "core security" rating requirement

applicable to synthetic securities packaged with a conditional

Demand Feature under the Rule.

The Series C RAWs mature in 22 months, and are

therefore Long-term debt obligations within the Rule, by virtue

of paragraph (a) (9), which defines "Long-term" to mean "having a

remaining maturity greater than 366 days." The Rating Agencies

have rated the Series C RAWs in their highest generic rating

categories. Thus, the ratings appear to be long-term ratings

within the meaning of the Rule, notwithstanding that they are

ratings customarily given to short-term instruments. Although it

is rather unique for a rating agency to assign a rating

customarily applied to short-term obligations to an obligation

with a maturity greater than 366 days, the F-1+, MIG-1 and SP-1

ratings appear to satisfy in substance the requirements of the

Rule. Moreover, this situation is distinguishable from the case

where an issuer or put provider has a short-term rating which is

higher than its long-term rating. There is no other rating by

the Rating Agencies of the Series CRAWs, and the F-1+, MIG-1 and

SP-1 ratings appear to have the functional significance of a

traditional long-term rating. Therefore, it would appear to be

an overly technical reading of the Rule, and inconsistent with

the Rule's significant reliance on the judgment of rating

agencies, to find that because the Rating Agencies used short-

term nomenclature to designate their ratings of the Series C

RAWs, the Synthetic Securities cannot be purchased by money

market funds.
Substantively, the Rating Agencies have determined that

the Series C RAWs are of high credit quality. The purpose of

requiring a rating of the core security for a synthetic security

is presumably to provide an additional element of protection to

money funds in the event that the conditional put is not

available because one of the conditions permitting the put

NYl-59189.2

(tRRICK, HERRINGTON
&: SUTCLIFFE

July 19, 1994

provider to avoid its obligation has occurred. The F-1+, MIG-1

and SP-1 ratings of the Series C RAWs appear more than sufficient

to provide this additional element of protection.

Long-Term Credit Ratings Of Consortium Banks

A concern has also been raised whether, notwithstanding

the ratings by the Rating Agencies, the Synthetic Securities may

not be Eligible Securities because not all of the Banks have

credit ratings in the two highest categories for Long- term debt

obligations. Therefore, the argument runs, if the Series CRAWs

were unrated so that a determination of credit quality depended

on an analysis of Bank ratings, the Bank ratings would be insufficient. However, the Series C RAWs are not unrated. Thus, a

fund has no choice but to look to the ratings assigned to the

Series C RAWs in making the Eligible Security determination. The

concern that funds might "game" the Rule by choosing to look

through to the rating of the underlying credit enhancers only

when it suited their purposes ís inapplicable in this context,

since the actual ratings assigned to the Series C RAWs preclude

reference to any other means of determining the creditworthiness

of the Series C RAWs for Eligible Security purposes.

For any synthetic securities where, as here, the "core

security" has been assigned an actual rating, there is no leeway

for "comparable quality arbitrage" by funds seeking to choose the

most favorable method of determining credit quality of the core

security. (Moreover, if funds were to be required to "look

through" to the credit ratings of the Banks, as a practical

matter, the presence of 14 banks with different credit ratings in

the consortium would make the comparable quality determination

difficult and unwieldy.)

Finally, while the terms of the Rule do not require

looking behind the ratings assigned by the Rating Agencies, which

are sufficient to provide the core security rating element

required by the Rule, if the staff were inclined to do so, we

believe that the Banks' short-term ratings should be taken into

account in light of the 22 month maturity of the Series CRAWs.

We note that within 9 months after issuance, both the Synthetic

Securities and the Series C RAWs will have actual final

maturities of less than 397 days. As mentioned above, the short￾NYl-59189.2

(tRRICK, HERRINGTON
&: SUTCLIFFE

July 19, 1994

term rating of each of the Banks is A-1/P-1 or the equivalent

(i.e. the highest generic rating category for short-term debt obligations) . Conclusion Based on the analysis set forth above, we would

appreciate your confirming that Synthetic Securities having the

features described above will be Eligible Securities for money

market funds under the Rule. If you have any further questions,

please feel free to contact the undersigned at (212) 326-8819 or

Michael Voldstad of this office at (212) 326 - 8806. Thank you for

your prompt consideration of this matter.

Adam W. Glass

NYl-59189.2